Aggregate demand is a schedule or curve that shows the various amounts of real domestic output that domestic and foreign buyers desire to purchase at each possible price level. The aggregate demand curve shows an inverse relationship between price level and real domestic output.

(The explanation of the inverse relationship is not the same as for demand for a single product, which centered on substitution and income effects. Substitution effect doesn’t apply within the scope of domestically produced goods, since there is no substitute for “everything.” Income effect also doesn’t apply in the aggregate case, since income now varies with aggregate output.)

The explanation of the inverse relationship between price level and real output in aggregate demand are explained by the following three effects.

Real balances effect: When price level falls, the purchasing power of existing financial balances rises, which can increase spending.

Foreign purchases effect: When price level falls, other things being equal, U.S. prices will fall relative to foreign prices, which will tend to increase spending on U.S. exports and also decrease import spending in favor of U.S. products that compete with imports (similar to the substitution effect).

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You need to distinguish between shifts in the AD curve and movements along the curve.

Shifts occur due to factors that lead people to demand more of the goods or services at a certain price.

Movements occur due to factors that change the overall price level.

Factors that cause movement along AD

The same factors that result from price changes. For example:

a) Real-balances effect

b) Interest rate effect c) International trade effect

These factors result in change in the QUANTITY of goods & services demanded.

Factors that cause shifts in the AD

1. Change in consumer spending:

Changes in real wealth

Changes in real interest rates

Change in expectations (income, inflation)

2. Change in Investment spending:

Interest rates

Expected returns

3. Changes in government spending

4. Changes in net exports

Change in foreign income

Changes in exchange rates

1. Consumer wealth is the difference between household assets (homes and stocks and bonds) and liabilities (loans and credit cards). The value of the assets can change and the consumer will react by spending more as asset values increase and spending less as asset values decrease.

Households can borrow in order to spend more which increases AD and if the household reduces spending in order to pay off household debt, AD decreases.

Expectations of future higher incomes or higher prices will increase current household spending and AD; expectations of lower household spending or lower prices will decrease AD.

A reduction in personal income taxes increases disposable income and increases spending by the household, increasing AD; an increase in taxes will decrease disposable income and decrease household spending, decreasing AD.

As real interest rates increase, the cost of borrowing increases and subsequently less will be borrowed resulting in less money spent, reducing AD. On the other hand, a decrease in real interest rates will increase borrowing and subsequently investment spending will increase AD.

If business owners and managers are optimistic about future expected returns they will spend more now increasing AD and if expected returns are less than favorable they will spend less now reducing AD.

3. Other things equal, if government spending increases, AD increases. An example would be of the government spending more on transportation projects.

If government spending decreases, AD decreases. An example of this is less military spending

4. If net export spending rises, AD rises. If net export spending declines, AD declines. As the national incomes of trading partners of the U.S. increase, they are more able to purchase U.S. produced goods and services which increases AD. If the foreign nations’ incomes decline, the opposite occurs.

If the dollar depreciates, AD increases. Depreciation of the dollar encourages U.S. exports since U.S. products become less expensive, as foreign buyers can obtain more dollars for their currency. Conversely, dollar depreciation discourages import buying in the U.S. because our dollars can’t be exchanged for as much foreign currency. AD can decrease through changes in currency exchange rates if the U.S. dollar appreciates. The currency appreciation of the dollar discourages U.S. exports because now U.S. goods are relatively more expensive than before since it takes more of the foreign currency to buy the U.S. dollar. This will also encourage more import spending since the U.S. dollar can buy more of another nation’s currency than before. Net exports will decline which reduces AD.

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Question

Consider just the AD curve. Suppose consumption (C) broadly increases across the entire economy. This will cause

A movement along the AD curve.

B the AD curve to shift outward.

C the slope of the AD curve to get steeper.

D a decrease in the price level of the economy.

Answer: B

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Question

The price level rises and this changes the real value of consumers’ wealth. Does this cause a movement along the AD curve, or a shift to a new AD curve?

Answer. This causes a movement along the AD curve

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Aggregate Supply (AS)

• The total supply for final goods and services in an economy

• The AS curve indicates the willingness of the producers to supply goods & services at different price levels.

Aggregate Supply (AS) – Cont’d

When considering the AS, we need to distinguish between:

Short-run (SR):

A period of time during which (some) prices are fixed (prices are NOT adjustable because they are determined by prior contracts).

Long-run (LR):

A period of time, long enough, for agents to modify their behavior in response to price changes.

Aggregate supply is a schedule or curve showing the level of real domestic output available at each possible price level. The relationship is determined on the basis of whether input prices and output prices are fixed or flexible.

In the short run, input prices are fixed but output prices are variable.

In the long run, input prices and output prices can vary

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Short-Run Aggregate Supply (SRAS)

Indicates the various quantities of goods and services that firms supply in response to the changing demand conditions that alter the price level.

Upward sloping (positive relationship between the price level and the quantity of the output to be produced)

Short-Run Aggregate Supply (SRAS) – Cont’d

SRAS curve is upward sloping (has a positive slope)

Because input prices are fixed, changes in the price level affect the firm’s real profit, which affect their decision of how much output to produce.

Factors that shift the SRAS

• Temporary supply shocks

• Changes in resource prices

• Changes in expected future prices

Examples

Long-Run Aggregate Supply (LRAS)

Indicates the relationship between the price level and quantity of output after necessary sufficient time has passed so they adjust their prior commitments.

LRAS is related to the economy’s production possibilities constraint

The constraints are imposed by the economy’s resource base, and level of technology, and the efficiency of its institutional arrangements – Not related to the price level.

Long-Run Aggregate Supply (LRAS)

In the LR, the economy moves towards the full employment level of output (Y*).

Y* is NOT affected by the price level.

LRAS is independent of the overall price level.

Long-Run Aggregate Supply (LRAS) – Cont’d

Factors that shift the LRAS

• Factors that determine economic growth, e.g.:

Change in the recourses available Changes in technology

Changes in the quality of institutions

Example

Important Note

LRAS shifts cause SRAS shifts…

However, the reverse is not true!

There are many factors that cause SRAS to shift but does not influence LRAS (for example temporary supply shocks that occur only in the SR).